As I explained in Part I of this article, the Swedish government has embarked on a carefully laid-out campaign to sway the minds of euro-skeptic voters. In a TV appearance recently, Johan Pehrson, Minister of Labor and a prominent member of the prime minister’s cabinet, expressed hope that the Swedish euro accession process could begin after the 2026 general election.
There are many good reasons why Sweden should not join the euro (and no good reasons to do it). I explained one of those reasons in Part I: it would gravely harm exports, the only sector in the Swedish economy that is actually growing. A shift from the krona to the euro would cause an effective appreciation of the Swedish currency, which of course means that companies selling products abroad would be hit by an enduring price hike.
Since the Swedes have a tax system that suppresses domestic economic activity, such a move would trap the economy in perennial economic stagnation.
The harm to exports and thereby to the only substantive growth generator in the Swedish economy is reason enough for Swedish voters to reject the common currency. However, there is another, equally important reason, on which I am going to elaborate here.
The stability and growth pact
As a member of the EU, Sweden is obliged to follow the fiscal rules laid out in the so-called stability and growth pact: budget deficits no bigger than 3% of GDP and government debt below 60% of GDP. These requirements become even more prominent for euro zone members, making them supersede any statutory requirements that the Swedish parliament would set up on its own. As a euro zone member, the Swedish government will have to design its fiscal policy first and foremost with the stability of the euro in mind, focusing only secondarily on what is best for the Swedish economy.
Currently, the European Commission does not enforce the stability and growth pact and does not expect to start doing so until at least 2024. However, for reasons I will get to in a moment, that can change on a dime. Therefore, it is essential that the Swedish government, when considering adopting the euro, takes into account the ramifications of invasive, Greek-style fiscal-enforcement actions by the EU and the European Central Bank.
As unthinkable as it may seem, what Greece went through a decade ago could prove to be a template for what Sweden could be subjected to when the country enters its next fiscal crisis. Back then, the EU and the ECB took help from the IMF to force Greece into fiscal compliance, in the bargain wiping out one-quarter of the Greek economy.
Last summer, when Croatia was preparing for its January 1st entry into the euro zone, I warned about the consequences of ending up on the receiving end of the euro-zone fiscal enforcement mechanisms. It is time to direct the same warnings to Sweden.
It is not difficult to predict the response from Swedish politicians and economists. They will refer to the country’s excellent public finance record: since 2000 the consolidated government budget balance in Sweden has been in surplus by, on average, 0.8% of government spending. This is a respectable record, one of the best in the EU, but it has also been accomplished at a price.
On the one hand, in terms of taxes as a share of GDP, Sweden has been able to lower its tax burden from the absolute top in the EU to a slightly more moderate 8th place:
Table 1
Source of raw data: Eurostat
On the other hand, tax revenue fluctuates closely with exports. This is due to the Swedish economy being more dependent on exports than it has ever been, and to the fact that the current tax system puts a heavy burden on private consumption and personal income. As a result of its close correlation with exports, tax revenue is quite volatile, and would fall permanently if exports were stifled by a shift from the krona to the euro. (The tax system in effect prevents households from replacing exports as a growth generator with increased private consumption.)
Budget instability
Figure 1 reports the changes over time in exports (red line) and in the consolidated government fiscal balance (black dotted line). The numbers are calculated as four-quarter moving averages to smoothen out short-term fluctuations.
Figure 1
Source of raw data: Statistics Sweden
Changes in Swedish exports normally precede changes in the government fiscal balance by 3-4 quarters. There are exceptions, of course, but the influence of exports on public finances in Sweden is too compelling to overlook.
Since exports is the only sector of the Swedish economy with any meaningful growth over time, its multiplying growth effects on the rest of the economy—including the bulk of the tax base—are essential to the solidity of government finances. Since it is highly probable that Swedish exports will stagnate under the euro, tax revenue will stagnate as well. This will lead to increased stress on government finances.
Meanwhile, welfare state spending will remain unchanged, and even inch up compared to a non-euro scenario, as lower economic growth leads to more people qualifying for welfare state benefits. Lower growth causes layoffs, and stagnant wages for those who still have a job.
In short, a euro zone membership will likely help accelerate Sweden’s path to a new fiscal crisis. The Swedish government is well advised to consider what the EU and the ECB would do at that point in terms of fiscal enforcement measures. The fact that Sweden has kept its government debt down over the past 20 years—as a ratio to GDP it is among the lowest in the EU—is no reason to believe that the Swedish government will be able to balance its finances in the future.
On the contrary: lower growth under the euro would create a structural deficit that could rapidly escalate into a real fiscal problem.
A structural deficit is a situation where government spending exceeds government revenue over a longer period than one business cycle. The combination of a structural deficit and a recession is particularly difficult for governments to deal with since the recession adds a cyclical deficit to the structural deficit. Incidentally, this was the situation in Greece when they were hurled into the dungeon of an acute fiscal crisis in 2009.
Harmful austerity measures
Runaway deficits are harmful to the integrity of the euro for two reasons. The first has to do with the ECB intervening with deficit monetization, i.e., the printing of money to buy treasury securities from the government with the uncontrolled deficit. Before the Great Recession in 2009-2011, few people expected the ECB to do any such thing—its constitutional document even prohibited such measures—but when the central bank intervened in multiple countries across the euro zone, it set a precedent for the future.
Simply put, wherever deficits become ‘bad enough’ the ECB can become an active investor in that government’s sovereign debt.
The other reason why runaway deficits threaten the integrity of the euro is the risk of investors abandoning an excessively indebted government’s debt securities. When investors partly or entirely lose confidence in a government’s ability to honor its debt obligations, they begin selling its securities. Large international investors will couple this with selling off euros, thus leading to a weakening of the currency. As this process begins, more and more investors will want to cap their losses by selling euro-denominated debt in general, as well as the currency itself.
By harming the currency itself, the flight from one euro-zone member’s debt gradually begins to harm other member states, including their ability to retain sovereign-debt investors.
The EU’s stability and growth pact plays an awkward role here. It formalizes investor expectations of a flight from the currency due to weaker fiscal positions among some countries. This feature of the EU constitution dictates that member states cannot run budget deficits in excess of 3% of GDP or let their government debt exceed 60% of GDP. Therefore, when investors identify countries on the brink of these measures, and when the macroeconomic context implies that further fiscal weakening is to be expected, these rules can work as a catalyst for investors to abandon a deeply indebted country.
Since the stability and growth pact is currently suspended, and will remain so for the rest of this year, the thought of the EU and the ECB intervening Greek-style in an indebted country remains hypothetical. Therefore, as the Swedes begin to debate a euro membership, the problems related to enforcement of the stability and growth pact are unlikely to surface in the public discourse. There will be little interest in the macroeconomic destruction that followed when Greece was forced into compliance with the pact.
The problem for Sweden is that even if the enforcement of the pact remains suspended by the time they join the euro (should they elect such a foolhardy move), the pact can be reinstated just as easily as it was suspended. More importantly, though, the fiscal and financial realities of budget deficits have not changed just because the European Commission lets fiscally lax governments get away with excessive deficits. Even if just one member state runs excessive deficits, the risk remains that investors shun the euro-denominated treasury securities and that major investors choose debt denominated in other currencies instead.
It does not take more than a small country like Greece or Sweden to set in motion an investor sell-off like this. If Sweden is the lead ‘deficit country’ in an economic downturn where many euro-zone governments are struggling to balance their budgets, the EU and the ECB could choose to come down harshly on the Swedish government. At that point, the Swedish parliament will be forced into policy decisions that have serious consequences for the Swedish economy but exhibit loyalty first and foremost to the integrity of the currency union.
I can hear Swedish politicians and economists object to this scenario, saying that Sweden has a statutory framework that prohibits excessive deficits. Therefore, they would argue, there cannot be any runaway fiscal crisis in their country. The problem with this reasoning is that it assumes that the laws that dictate fiscal policy can supersede the realities of an economy in stagnation or decline. That, of course, is not possible: once a euro zone membership brings to a halt the growth-generating economic activity in the Swedish economy, public finances will fall like dominoes.
Given the overall fragility of the Swedish economy and therefore the government’s tax base, the path to a deep fiscal crisis is both short and swift.
It would be rational to expect Swedes to not want to go down that path. Their country went through an episode of very harmful austerity measures in the 1990s, with seriously negative consequences for the economy as a whole. It was not quite as bad as the Greek austerity experience: the Swedish one ‘only’ destroyed 7% of the economy, while in Greece one-quarter of the economy was wiped out. Nevertheless, there is no way that the Swedish economy as it is today, much less Swedish society, would be able to absorb the shock of a crisis-style package of austerity measures.
From a policy viewpoint, it does not matter if Sweden independently decided to handle a fiscal crisis like it did in the 1990s, or if the policy measures were dictated by the EU and the ECB. However, from a political viewpoint, it matters a great deal who is in charge when the fiscal crisis hits. If it is the EU, then Swedish public opinion will react much like it did in Greece and favor political parties that are passionately opposed to EU membership.
Those parties tend to be extreme in their overall political leanings. To have a political spectrum increasingly populated by the far right and the far left would be the cherry on top of the crisis cake that Swedish proponents of the euro are baking for their country.
